A reverse merger happens when a publicly trading company merges with a private company and the private company survives, occupying and operating in the publicly traded company's legal shell. The private company takes over controlling ownership of the stock of the public company and management of the company, usually changing the company's name to its own and changing the stock symbol. It is not necessary for both companies to be in the same business; in fact, usually they are in very different businesses.

Reasons for a Reverse Merger

When a public company begins a decline into financial failure, the only asset left often is the legal public corporate shell. The stock continues to trade, generally supported at a specific price by market makers. If the stock is trading on an exchange, the price is supported to meet the share price requirements of that exchange, but only a minimum number of shares actually trade. This is done to maintain the value of the trading shell. The most common reason for a reverse merger is the desire of a private company to quickly become a public company. The alternative is a long process involving SEC registration. A reverse merger circumvents the SEC registration process and replaces the failed company with a company that has operations and, hopefully, better prospects. Foreign companies seeking to trade on U.S. markets also make use of reverse mergers. Once the reverse merger is completed, the new company usually issues additional stock to raise capital.

Original Shareholders

If you are an original shareholder in a failed company that is planning to go through a reverse merger, you will have a chance to vote on whether to accept the merger. Since your stock is essentially worthless, voting for the reverse merger might seem to present hope of eventually recovering your investment. You will receive a certain number of shares in the new company in exchange for your original shares, but that number will be considerably smaller than the number of shares in your original holding. For example, the new company may trade 25 percent ownership for the public shell. If the new company has 100 million shares authorized, it gives 25 million to the original company's shareholders. If the original company had 250 million shares issued, each shareholder will receive one share of the new company in exchange for 10 original shares. In this example, if you owned 1,000 shares of the original stock, you would receive a certificate for 100 shares of the new stock.

Reverse Split

Some new companies employ a further strategy to increase the number of shares available for use in raising capital. Since the new company has controlling interest, it holds a shareholder vote to reverse-split the authorized number of shares from 100 million to perhaps 10 million and, in the example, as an original shareholder, your number of shares will be reduced from 100 shares in the new company to 10 shares. This would be a 1-for-10 reverse split. The company then holds another vote to authorize 200 million more shares and issues 100 million new shares to raise capital. This further dilutes the value of your original shares. Many companies that have gone public through reverse mergers have large numbers of shareholders who own 10 shares or fewer.

Shareholder Approval

Shareholder revolts have stopped some reverse mergers in favor of finding other private companies that would be better merger candidates. This has its risks, but if a company with good prospects agrees to protect the original investors -- even though the original investors will see their percentage ownership diluted somewhat -- they may not be subject to further dilution. The risks of blocking a reverse merger might mean that no private company can be found to take over the shell and your stock remains worthless.

Photo Credits

About the Author

I have 14 years of experience working with alcoholics and would like to write about this subject. I have included some of my articles on business and Internet marketing, but I am also capable of writing and editing other subjects.

At the center of everything we do is a strong commitment to independent research and sharing its profitable discoveries with investors. This dedication to giving investors a trading advantage led to the creation of our proven Zacks Rank stock-rating system. Since 1986 it has nearly tripled the S&P 500 with an average gain of +26% per year. These returns cover a period from 1986-2011 and were examined and attested by Baker Tilly, an independent accounting firm.

Visit performance for information about the performance numbers displayed above.